Thread by @shiftingshares

Most people agree that PhDs are clever.

But in a trading experiment where 40 PhDs won 60% of the time - 38 out of 40 lost money.

Why did this happen? Position sizing.

Here's how to increase your trading profits with effective position sizing.

[THREAD]

Each PhD started with $10,000.

They risked capital on 100 turns and they both won and lost what they risked on each turn. Risk $1 to win or lose $1.

But almost all of the PhDs risked too much capital early in the game.

Greed and a lack of understanding odds were big reasons.

Gambler's fallacy was also an issue.

Some PhDs believed that they were 'due a winner' after a string of losers. But each trade never has any effect on the next.

However, each trade did affect their starting capital in an exponential manner.

Here's how:

A PhD who risked $1,000 four times and lost each bet was down 40% of their starting capital.

But to get back to breakeven this required a gain of 66.67%.

Five losing trades of $1,000 meant a 50% drawdown and a 100% gain to get back to breakeven.

The most important question any trader should be asking is: "How much should I position size?"

Position sizing will determine how successful you are in your trading and protect you from blowing up.

You should scale positions up when winning and down when losing.

Here's why:

Let's say you have a £50,000 account.

You trade with £10,000 positions with a 20% stop.
Your risk per trade is £2,000 or 4%.

You have five losing trades in a row and now have £40,000.

A £10,000 position with a 20% stop makes your risk now 5%.

Your risk has increased by 20%.

Scaling down your positions to £8,000 with a 20% stop takes your risk down to £1,600.

Your risk is now back to 4%.

These numbers are not suggestions.
Your account risk per trade is up to you.

The example is to show how risk can steadily increase as an account is in drawdown.

Position sizing brings two problems:

1) Size too large and you blow yourself up
2) Size too small and you're not invested in the trade

You need to be invested in the process.
Not the outcome.

Size enough for it to mean something.
But not too large to put your account at risk.

You have a 60% strike rate that wins 2, loses 1.

You lose your first 4 trades and win the next 3.

If you use:

- 5% risk: you're up 10%
- 10% risk: you're up 20%

But can you handle losing 10 trades in a row?

Using 5% you'd be down 50%.
Using 10% you've blown your account.

You can have the most profitable strategy in the world.

But use poor position sizing and you'll still lose money.

The lower your risk per trade the more potential failure you build in.

Using:

- 1% risk: you're up 2%
- 2% risk: you're up 4%

But more importantly: you buy time.

Almost everyone (myself included) wants to make money quickly.

But trying hard to make easy money is an easy way to lose hard-earned money.

The house edge on roulette is only 2.63% but you'll never see a bust casino.

Buy time for your edge to play out. Size small; scale down.

There are two ways to calculate position size:

1) Monetary risk

To work this out: Monetary risk/risk per share (entry minus stop) = no. of shares

Example: I'm risking £500 on a trade. I enter at 15p but I'm cutting my loss at 11p.

Therefore, the calc is £500/4p = 12,500.

Keeping risk constant is important for any trader.

Your P&L will show inconsistent results with inconsistent risk.

Inconsistent results lead to inconsistent profits.

Your journal needs consistency so you can understand where you're making mistakes, and how you can fix them.

The monetary risk method allows us to adjust our position size for risk.

Keeping consistent position sizing is for amateurs.

Let's say I want to buy a stock at 20p.

Buying £10,000 and exiting at 15p or 12p will result in different losses.

Adjusting size for risk fixes this.

2) Account risk

To work this out: Percentage of account in GBP/risk per share (entry minus stop) = no. of shares

Example: My account is £100,000 and I'm risking 5%. I enter at 50p and close at 40p.

Therefore, the calc is £5,000/10p = 50,000 shares.

This second method is more advanced and for those who are varying risk.

But if you're varying your risk - you should know why.

1) What are the odds on the trade?
2) Downside risk?
3) Do you have an edge?

Or are you increasing your size because you've "got a good feeling"?

Both of these methods are available as a free calculator tool on my website.

shiftingshares.com/position-size-…

You also have to factor in liquidity.

This is something armchair and theoretical traders overlook.

Liquidity is a double-edged sword for position sizing.

Here's why:

Buying shares in low volume/low float stocks may mean you struggle to exit.

But it also makes it difficult for people to buy.

If you believe you have an informational edge in a special sit, then this can be your friend.

Just remember: always check your exit before your entry.

You can also split your position sizes to increase your expectancy.

But that's a thread for next week.

If this was helpful, follow @shiftingshares for more threads on trading and money management.

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